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Economic Integration and the Optimal Corporate Tax Structure with Heterogeneous Firms

  • Christian Bauer
  • Ronald B. Davies
  • Andreas Haufler

We study the optimal combination of corporate tax rate and tax base in a model of a small open economy with heterogeneous firms. We show that it is optimal for the small country's government to effectively subsidize capital inputs by granting a tax allowance in excess of the true costs of capital. Economic integration reduces the optimal capital subsidy and drives low-productivity firms from the small country's home market, replacing them with high-productivity exporters from abroad. This endogenous policy response creates a selection effect that increases the average productivity of home firms when trade barriers fall, in addition to the well-known direct effects.

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Paper provided by School of Economics, University College Dublin in its series Working Papers with number 201115.

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Length: 36 pages
Date of creation: Aug 2011
Date of revision:
Handle: RePEc:ucn:wpaper:201115
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